- The Fed is normalizing interest-rate policy while monitoring the impact of late-cycle stimulus
- U.S. interest rates are diverging more widely from non-U.S. interest rate levels
- While keeping a close eye on the ECB, we see a potential opportunity for global yield curve strategies
The new chair of the Federal Reserve, Jerome Powell, faces the challenging task of normalizing monetary policy as fiscal stimulus is being uncharacteristically introduced late in the business cycle. We believe this shot of economic adrenaline will lead the Fed further down the tightening path. As financial markets continue to adjust to this reality, we believe opportunities will appear for patient investors.
The Fed is monitoring stimulus
At this juncture of the economic cycle, stimulative fiscal policy is contrary to what most academic textbooks would recommend, partly because it increases the risk of the economy overheating and running into capacity constraints. To illustrate this point, note how unusual it is for the U.S. unemployment rate and the U.S. fiscal deficit to be moving in opposite directions.
The Fed is cognizant of this developing backdrop, and we believe this will prevent them from being too dovish as they pursue their dual mandate of maximum employment and stable prices. Of course, that could change if the Fed’s unofficial third mandate — maintaining global financial stability — comes under threat due to a large exogenous shock. However, absent a shock, investors should not doubt the Fed’s resolve in extending their rate hiking cycle.
Global yields are diverging
As the United States has taken the lead among its developed peers in normalizing both policy rates and its balance sheet, global interest-rate differentials have widened significantly. For example, the spread between U.S. and German nominal yields has reached its widest level in decades.
Part of the reason for the recent divergence is that investors have priced in a U.S. fiscal policy that differs sharply from those in other advanced nations. The Tax Cuts and Jobs Act of 2017 was signed into law on December 22, when synchronized global growth was in full swing. Since then, the data has remained firm in the United States while it has softened in regions such as Europe. The Citigroup Economic Surprise Index, a broadly tracked measure of actual data versus expectations, has edged down in the United States, but in Europe it has dropped to its lowest level since September 2011.
We would argue that financial asset prices have already adapted to this information flow, helping to explain recent changes in yield differentials.
Fortunately for European growth prospects, one consequence of these extreme movements in relative interest rates has been that the recent broad-based strengthening of the U.S. dollar has halted the relentless rise of the euro. Given its reliance on exports to fuel its economic growth engine, Europe welcomes a weaker currency. Undoubtedly, the strength of the euro since the end of 2016 has negatively affected both economic and inflation data that has been released during the past several months. The recent weakness in the common currency will have a stabilizing impact and help improve investors’ sentiment in the quarters ahead, as long as political risks are contained. Any rebound in growth expectations and inflationary trends in Europe will give the ECB more confidence that the ultra-suppression of their interest rates is no longer necessary.
The potential opportunity we see
At this stage, we would argue that the Fed’s intention to tighten monetary policy further, especially as fiscal stimulus begins to feed into economic data, has already driven interest-rate and currency trends. Further spread widening is certainly possible in the short term, especially as the ECB has recently introduced strong calendar-based forward guidance which should anchor the front-end of the yield curve throughout the rest of this year. A stronger catalyst for convergence will likely appear within the next several quarters although global forces will likely cap the upside in these spread differentials. Therefore, we believe that long-term investors will be rewarded if they start to position for contraction in the historically wide interest-rate differentials between U.S. and German bonds, especially in the belly of the curve. The risk-reward trade-off may be too enticing for patient investors.